The ASIC Report: the first defence against financial fraud

Undetected financial fraud is one of the greatest risks to an organisation’s viability and corporate reputation. It has the capacity to draw into its sphere all associated people, not only the guilty.

The role of company directors and a sound corporate governance framework are crucial to ensuring that financial reports accurately reflect the true financial position of a company and are clear of material financial fraud.

In ASIC’s experience, material financial fraud is one of the key factors evident in corporate collapse and preventing this fraud is one of the key future challenges for ASIC and business alike.

Companies collapsing through commercial causes – for example, Ansett – are in the minority. However, collapses such as Worldcom, Enron, Adelphia, Parmalat and, in Australia, HIH, Clifford Corporation, and Harris Scarfe each involved an assortment of systematic fraudulent actions.

In many cases, fraudulent activities were facilitated or disguised by a range of factors, including:

• weak and ineffective boards of directors dominated by a charismatic, imperious chief executive;
• lack of internal controls and inadequate corporate governance structures;
• corporate cultures that ‘covered up’ problems;
• breaches of directors’ duties, including reckless and inappropriate behaviour, corruption and greed;
• auditors who are not independent or sufficiently critical;
• poor or misleading disclosure to the market; and
• gross mismanagement of the business.

In response to these collapses, we have seen legislative and quasi-legislative measures pop up around the world. These responses have been important in changing behaviours and increasing confidence, but they are not primarily focused on financial fraud – that is, governance and financial reporting. They do not target the fraud itself.

How, then, is that best achieved?

As a first step, fraud detection and prevention must occur within the organisation. Material financial fraud is, by definition, difficult to detect and it has the frightening ability to put at risk the ongoing sustainability of the enterprise.

It is often perpetrated through either ‘collusion fraud’ or a ‘culture of fraud’ that tolerates or facilitates fraudulent acts, paving the way for certain company demise. Single frauds, though more common, are seldom threatening to a company.

Prevention and detection naturally comes down to a strong corporate governance framework and the integrity and honesty of those individuals within the organisation who have the responsibility to prevent financial fraud.

A strong audit committee that challenges and probes the company’s management, advisers and auditors is, in my view, a necessary foundation for the ongoing financial health of an enterprise.

Over the last ten years, substantial strides in the evolution of the audit committee have occurred. It is now one of the key elements within an enterprise for transparency and accountability and it is the unique point at which many crucial individuals come together to interact and report.

Indeed, it could be suggested that the evolution of the audit committee is far from over. Should it be playing a bigger role in preventing material financial fraud? I think so, but what should that role be? What further changes could be made to the composition of the audit committee to improve it?

A particularly important issue to consider is its composition. It is crucial that corporations have a strong, probing and clearly independent audit committee. A strengthening of the duties and responsibilities of the audit committee in respect to preventing and detecting material financial fraud will also be an important step in the fight against such fraud. The most obvious way to achieve this would be through company charters, although it could also be considered in law.

Another issue for us to consider is the role of the auditor and auditing standards. A reliable financial report cannot be produced without some comfort on everyone’s part to ensure the numbers are not tainted or used to hide a material financial fraud.

To achieve such comfort in Australia, I would suggest the need for a strengthening of the audit standards and appropriate internal controls. This would ensure that audit committees engaged with the company’s methods of internal controls as well as the role of the governance and compliance framework within the company.

Strong internal controls and probity of an independent audit committee are necessary measures for an organisation seeking to prevent financial fraud.

Obviously, the most efficient way to improve these measures is for the organisation itself to implement effective corporate governance structures and arm its audit committee with a charter to test, detect and root out financial fraud.